Fragile China: attractive Chinese stocks need care

Chinese stocks still offer some high growth prospects, though there are also plenty of headwinds as the government navigates elevated debt levels and a possible housing bubble.

Behind the scenes, the Chinese authorities are grappling with a variety of economic dilemmas. There are undoubtedly risks ahead as the government continues its attempts to ween the country away from leverage and cool a runaway housing market.

The Chinese government, however, is extremely keen for foreign investors to raise their allocation to the country, having taken measures to open up both its equities and bond markets.

In June, the MSCI announced that Chinese equities had been granted a place in the MSCI Emerging Markets index, a sign of the country´s increasing acceptability as part of global investors´ portfolios.

Institutional investors had previously railed against the inclusion of China A-shares in MSCI´s index due to worries over the regulations surrounding China´s equity market and the related costs.

The reason for the sudden change of heart? MSCI claimed investors had warmed to the idea due to the success of China´s Stock Connect programme, which links Hong Kong with the Shanghai and Shenzhen stock markets on the mainland.

It means foreign investors are now able to tap the China A-share market without having to comply with the mainland´s capital restrictions.

Chinese bonds

Early this month, China took a further major step to opening up its capital markets to foreign investors with the launch of its Bond Connect scheme.

Following the success of the Stock Connect programme, which first launched in 2014, the fixed income equivalent means overseas investors no longer need to have an onshore account to purchase Chinese bonds.

Major barometer

China took the mantle of the second biggest economy on earth in 2010. It had already long since become a major barometer for international investors given its impact on global commodities demand as well as the increasing proportion of blue-chip corporate earnings derived from the country.

A big worry for investors over recent years has been the rampant price growth in China´s housing market and the growing levels of consumer and corporate debt in the country.

Property hotspots

Some of China´s property hotspots have clocked up some spectacular growth over recent years. Since 2003, Shanghai´s second-hand home prices have risen by around 300%.

In recent years, meanwhile, some of the biggest rises in Chinese property have been registered in technology hub Shenzhen, which is commonly referred to as China´s “Silicon Valley”. The city´s home prices rose by around 75% over the two years to the end of 2016.

As house prices have risen, so have the nation´s borrowing levels. By the end of 2016, the country´s debt had ballooned to 260% of GDP.

Shanghai City, China.

China economy

Official figures showed China´s economy modestly beat expectations during the second quarter of 2017, with annual growth of 6.9%. However, to the chagrin of the Chinese authorities, much of the country´s economic growth is still coming from the housing market.

Despite government efforts to cool the market, property investment accelerated by 8.5% over the first half of the year, outpacing the 6.9% growth registered over the same period during 2016.

The latest available figures show new home prices across 70 Chinese cities rose by 10.2% year-on-year in 2017.

Chinese stocks

The Chinese stock market, meanwhile, has also been generating decent returns of late. Mainland Chinese equities have risen by over 20% in US dollar terms over the past year, outpacing a return of around 17% for global equities in general over the same period.

Overall positive economic news from China is helping to prop up Chinese equities as a whole, but the imbalances in its economy and the failure of the authorities to rein in rampant growth in the housing market means investors should tread carefully.

Rather than positioning themselves for growth from Chinese equities as a whole, investors could therefore do better if they target certain individual names instead. It´s probably wise to avoid those stocks most exposed to the fortunes of the property market.

China´s rural-to-urban immigration and growing middle class have long been cited as exciting themes for investors.

Exciting themes

China´s rural-to-urban immigration and growing middle class have long been cited as exciting themes for investors. The best returns could still be had from those stocks most exposed to China´s longer-term consumer growth story.

While there´s bound to be some peaks and troughs along the way, Chinese technology names with exposure to domestic consumers could continue to generate strong returns over the longer term.

Internet growth

The number of Chinese internet users has been growing in multiples over recent years, providing a huge boon to Chinese internet names. There is still enormous potential for further growth as more of the country´s population of over 1.3 billion goes online.

By the end of 2016, the number of Chinese internet users had risen to an astounding 731 million, equal to 53% of the population, according to official data from the country´s China Internet Network Information Centre. The country had 210 million internet users as at the end of 2007.

There is some way to go before China reaches the level of internet penetration of the US, where 88% of the population uses the internet.

Chinese tech stocks

Among the big Chinese internet stocks that have a good chance of profiting from this trend are names such as e-commerce giant Alibaba, Twitter-like micro blogging platform Weibo, search engine Baidu and Tencent, which is best known for its WeChat app.

While the valuations may not appear to be cheap on the surface, their strong growth potential means such names deserve a second look.

Tencent for instance commands a price-earnings (P/E) multiple of 54 times. Considering some of the US internet names have P/E multiples of around 200 times, this shouldn´t put too many people off.

Getting exposure

While the Chinese government´s initiatives such as Stock Connect have made it easier for foreign investors to gain a broader exposure to the Chinese stock market, many big Chinese companies like Tencent already have listings outside the mainland. The latter is listed in Hong Kong.

Other big Chinese names, such as blue-chip telecom group China Mobile, are listed in New York. China Mobile is well placed to benefit from the increasing penetration of mobile data services across China.

Attractive long-term prospects

There clearly are some risks to investing in Chinese shares. The mixture of state control and capitalism can be confusing at times, leaving investors feeling frustrated by a general lack of transparency.

Recent Chinese economic data has been good, but then there are still the worries over how things could unfold if the government does succeed in slowing down the domestic housing market.

Given the continued high level of state control, investors should certainly never take anything for granted.

Over the long term, however, this growing economy of well over 1.3 billion people should continue to provide investors with some very attractive investment opportunities.

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